Barclays Helps Hedge Funds, Hurts Ordinary American Taxpayers

Summary

The US government alleges that Barclays bypassed tax laws to help a number of hedge funds, engaging in "basket options" to hide liability.

Costs for such mishandled financial dealings often accrue to the American taxpayer.

With Barclays' investment bank in rapid decline, reflected in a 20% drop in Q1 earnings, we suggest investors look to other financials in 2014.

Barclays Bank (NYSE:BCS) finds itself among the many financial institutions in trouble with the government. In BCS' case, the bank allegedly bypassed tax laws to help a number of hedge funds.

A Senate panel finds the bank had utilized "dubious" financial products to help these funds avoid taxes and do an end-run around federal laws regarding risky investments.

The practice resulted in helping wealthy investors at the expense of ordinary taxpayers, who would be expected to pick up the bill when these investments went wrong.

Skirting the Rules

An investigation found that both Barclays and Deutsche Bank (NYSE:DB) engaged in "basket options" to hide tax liability for the hedge funds with which they did business.

These financial products were characterized as options held nominally by the bank, but that were, in fact, held by the hedge funds. One fund skirted an estimated $6.8 billion less in taxes than if the profits had been taxed as they should have been - that is, as short-term gains.

Options held in this way also allowed the funds to take on more risk, threatening the stability of the entire financial system.

U.S. Senate Panel

The Senate subcommittee was led by Senator Carl Levin of Michigan and Senator John McCain of Arizona. The year-long investigation focused on two of the biggest beneficiaries of the questionable financial products, Renaissance Fund and George Weiss Associates.

Not only did the basket option tactic allow the two funds to avoid significant tax burdens; it also allowed them to borrow amounts far above the federal leverage limit for Wall Street firms. The Internal Revenue Service has clearly stated that basket options do not function as traditional options and cannot be taxed in the same way.

As a result of the investigations and subsequent findings, Barclays has decided to sell off its investment interests, laying off one in four of its employees in the process.

American Taxpayers At Risk

During the financial crisis of 2008, the American taxpayer was asked to step in to foot the bill for a number of mishandled financial dealings that rocked the stability of the global financial system. Since that time, the public has fully supported any effort to prevent a repeat of the credit default swaps and securitization of mortgages that were at the heart of the crisis.

Increased efforts by the Consumer Financial Protection Bureau, which oversees the public's interests, and increased scrutiny by the federal legislature, are two measures implemented in the hopes of heading off any further disruption of the financial system by reckless actions of investment banks.

Holding Barclays accountable for aiding reckless financial practices is considered a necessary step in the maintaining the continued stability of the financial marketplace.

The repercussions from Barclays hedge fund shenanigans are likely to ripple through the investment community for some time.

Despite the company's statements reaffirming that the bank was in full compliance with current law, the public's intolerance of further investment misconduct is likely to adversely impact the bank's reputation and stock price for some time to come.

Barclays shaving off the majority of its investment bank, due to CEO Anthony Jenkins going over-budget, already stands to significantly curtail the bank's global reach, operations, and ability to compete with mega-bank peers, such as Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) - both of which have pulled ahead of BCS YTD and maintain very strong and diverse business platforms.

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(Nasdaq.com)

On May 12th, RBC Capital Markets downgraded BCS to Sector Perform from Outperform, following a 28% drop in income.

BCS' Q2 results could likely be minimized, as negative news builds.

We suggest investors consider Morgan Stanley or Heritage Insurance (NYSE:HRTG) as alternative financial holdings in the second half of 2014.

We invite readers wishing to join the discussion on Barclays to click the +FOLLOW button above the title of this article -- and those looking for the latest developments to click +Get real-time alerts.

Disclosure: The author is long HRTG. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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